How charity investors should cope with market volatility
The legendary investor Warren Buffet stated in an interview in October 2008, at the height of the credit crisis, "You want to be greedy when others are fearful. You want to be fearful when others are greedy. It's that simple."
While markets in 2016 have not been as fearful as they were in 2008, we have seen a heightening of volatility over the last three months. Although investors had expected more volatility for financial markets over the course of 2016, such steep equity and credit market falls in the first month of the year took many by surprise. Worries about China’s slowdown and its impact on the global economy, further sharp declines in commodity prices and a significant widening of corporate credit spreads all contributed to negative sentiment.
Risk appetite then bounced back from mid-February and since then emerging market equities and currencies have outperformed, the spread on government bond yields compared to corporate bonds has compressed and oil prices have rebounded strongly.
While markets have stabilised somewhat, we have of course the upcoming referendum on the UK’s membership of the European Union, which is likely to provide a further test to markets this summer. Risks of central bank policy missteps and the US inflation outlook are both factors that that will receive the market’s attention later this year.
With this backdrop, it is tempting for trustees to consider whether it is worth the effort to invest, given the bumpy ride and paltry returns. Is the possible loss of capital worth the risk of investment when a charity could sell and put the money in the bank?
Low risk attitude
One of the paradoxes that exist with charities and their investments is that most charities are established in perpetuity, while their trustees are usually around for a limited period of time. It is not unreasonable for the average trustee to take a low risk attitude with their investments in order to avoid capital loss while it is their responsibility. Against this, historic and academic studies of investment returns, such as the Barclays Gilt Equity Study that shows UK asset class returns with income reinvested since 1899, demonstrate that taking risk and investing with a long term can often offer better returns.
To make matters worse, there is a tendency for investment managers to focus on monthly or quarterly returns which, as demonstrated so far this year, can make for frightening reading. Furthermore, the regulatory requirement to report discrete annual performance for the previous five years tends to focus retail investors on short term returns.
Ultimately, trustees should invest in line with the charity’s proscribed investment policy statement. This can often be quite vague and, without reference to specific criteria, refers to investing in a "balanced portfolio", or "taking medium risk", and the need to "maintain capital and income" in the long-term. Charities which have adopted a total return approach often refer to investing with the need to exceed the return of inflation plus "x"% over a rolling number of years.
No matter what approach is taken, getting the best return while taking the least amount of risk or volatility of return makes sense as this will likely provide a degree of consistency in investment performance. Ultimately, the charity needs to have trust in its appointed fund manager to produce the expected returns and not be tempted to sell at the first sign of underperformance or heightened market risk.
If the charity takes a long term view with its investments, to meet the needs of current beneficiaries as well as those in the future, and outsources investment decisions to an external manager, it is the manager’s job to weather any storm that appears on the horizon with active management of the underlying investments. The better relationships between a charity and its investment manager are due to clear expectations being set in both directions.
Multi-asset approach
There are a number of ways a charity can manage the short term volatility. Adopting a multi-asset approach to investment is a good start, as the following chart demonstrates. It looks at the weekly total return (capital and income reinvested) of UK shares and UK government bonds since February 2006. For comparative analysis, a blended notional portfolio of 50% to each of these assets is also plotted to show the past performance of a simple mixed asset fund. While UK bonds have performed unusually well over this period, the blended asset portfolio has performed better than equities with significantly less volatility than either asset class.
Diversification also works at a single asset class level. If we use the example of the BP Deepwater Horizon oil spill on 20 April 2010 in the Gulf of Mexico, and compare this with the performance of the UK equity market over this period, the risk of overinvesting in a single stock is clear. The same example could be used with the effect of Volkswagen’s admission to cheating on diesel emission in September 2015, when the company’s shares fell 23% on the Frankfurt stock exchange in one day.
Trying to time the markets is often cited as a means to maintain or grow value. Sadly this is rarely the case as shown by simple analysis of the impact of attempting to call the market. Looking at global equities, as demonstrated in the MSCI World Equity Index in Sterling terms from 31 December 2005 to 31 December 2015, if an investor missed the top 10 performing days during this 10 year period the overall value of the investment would reduce in value by as much as 75%. Missing the top 30 days would see the return fall to -31.2% (MSCI World Equity Index (£) from 31 December 2005 to 31 December 2015. See the chart below).
Further analysis demonstrates that retail investors have a tendency to buy into a rising market and sell when they anticipate poorer performance. A working paper by Andrew Clare and Nick Motson of the Cass Business School’s Centre for Asset Management Research (CAMR) looked at the median UK retail equity investor and assessed that this typical buy and sell behaviour had effectively cost a cumulated total return of 20% over the last 18 years. This effect is compounded when investors who have sold have a tendency to buy back into the market when it has already risen.
Cash in itself can be a buffer to weaker investment returns but it can also be a weapon. Holding a reasonable amount of cash in a diversified portfolio is useful as it offers a charity the ability to invest when certain assets may appear cheaper following dislocations in markets. Holding too much cash will drag on performance over the long term, given the nominal returns available for cash deposits. Furthermore, if a charity is looking to grow its overall endowment and income at least in line with inflation, cash will erode the real return of the capital in the long term.
Regularly review policy
In conclusion, a charity which has surplus capital to invest should take a long term view, have a clear strategy, set a realistic objective for the investments and stick to this policy. The role of the trustees and their investment manager is to regularly review this policy in light of the changing financial position of the charity and fundamental changes in the markets. Trying to foresee the occasional mountain that may in fact be a molehill is a difficult art. Provided the charity has sufficient cash reserves to maintain its mission, it should remain invested though good times and bad.
